How to Survive an Emotion-Fueled Market

Emotion is taking over the market. On any given day (or maybe any given hour!) the U.S. stock market can swing by several percent based on a rumor, a flimsy blog or by a statement by a central banker or world leader.

In one brief four-week period, the fear of return of capital has been replaced with the fear of an inadequate return on capital as fear of the downside has been replaced with fear of missing the upside.

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."-- Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

Today's opening missive will not debate the merits of today's stock market valuations, but rather address the role of emotion in the investing equation. (I would, however, remind readers that while the outsized gains in the month of October 2011 qualify among the best 10 monthly gains in history, every single one of those 10 large monthly gains occurred within the context of secular bear markets (hat tip "Uncle" Bob Farrell!).)

The emotions of both fear and greed keeps us from making as much money as we ought to.

The Oracle of Omaha, Warren Buffett, has often written about the madness of investing crowds and why it often pays in the long run to be a contrarian:

"You can't buy what is popular and do well."

"Most people get interested in stocks when everyone else is. The time to get interested is when no one else is."

"You're neither right nor wrong because other people agree with you. You're right because your facts are right and your reasoning is right -- and that's the only thing that makes you right. And if your facts and reasoning are right, you don't have to worry about anybody else."

"A public-opinion poll is no substitute for thought."

"The most common cause of low prices is pessimism -- sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer."

"If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."

And above all, let's be attentive to Buffett's observation below that applies as much to today's market as it did when he wrote this quote several decades ago:

"Remember that the stock market is manic-depressive."

I have long written that the crowds usually outsmart the remnants, but in today's emotionally charged and volatile market (which demonstrates no memory from day to day) confusion reigns and the crowds seem to bend with the emotion (and news) of the day.

What's causing these rapid changes in sentiment, and how should the average investor respond?

Arguably this manic crowd behavior (manifested in the ups, downs and insane volatility that follow) is reflected in the mood swings from depression to euphoria that have been goosed and exacerbated by the media, by performance-chasing investment managers and by high-frequency trading, momentum-based strategies and levered ETFs. We must try to stay (and invest) above the hype, avoid the pressure to "get in" during vertical moves (and to sell during deep swoons) and continue to try to take advantage of the volatility served up by the robots (rather than having it sap our confidence).

Let me briefly go over three influences that we must put into perspective:

Media

"You don't realize how easy this game is until you get up in that broadcasting booth." -- Mickey Mantle

The business media's role is to objectively and without prejudice tell "the score"; provide a market perspective (in describing what the market is doing and why); present other professionals' opinions of individual companies; analyze the economy, economic releases and news; and interpret government and central bank policy -- all for the purpose of improving the public's understanding of the market's influences.

"The media has a tendency to amplify emotion (especially to the upside!!) and has a ... peculiar tendency to view the world as if reflected in those fun-house mirrors ... with the relentless maw of endless outlets in need of attention-grabbing headlines. ... There is no market news that says, 'Things aren't so bad, but they're not great either.'"

The media is too often positively biased (though there are occasionally some exceptions) and their objectivity is sometimes lost in their cheerleading and chorus of "Everything's Coming Up Roses."

Who can blame them for the use of their bully pulpit, as there are obvious reasons for this. The media has a vested interest in stocks rising; their audience (and ratings) contract in times of market downturns and advertising suffers. If things turn really bad, their salaries and employment status may be adversely impacted. The market's theatre (sometimes of the absurd) is far more exciting when stocks are in the green rather than in the red. As a result (and almost regardless of market environment), bullish "talking heads" who appear in the media routinely outnumber bearish "talking heads."

One should not be surprised that despite the reality of the moment and quality of future analysis, downbeat forecasts and outlooks (as Karabell mentions above) are not what investors normally want to hear.

A little-discussed secret is that representatives of significant media advertisers (print, radio and television) often appear with greater regularity than other "guests." This helps to explain, in part, the media's sometimes limited criticism of glib, formerly wrong-footed bulls (names are excluded to protect the guilty!) -- many of whom failed to see the drop into the debt and equity abyss in 2008-09 -- compared to the relative quickness in criticizing recently wrong-footed bears like David Rosenberg, Nouriel Roubini and Meredith Whitney.

Back in 1973 the first health warning appeared on cigarette packaging -- "Warning - Smoking is a Health Hazard." Perhaps in 2011 it should be legally mandated that guests/talking heads in the business media disclose that their employers are important advertisers on the platform on which they are appearing. After all, when I or anyone else mentions a stock in the media, a disclosure of ownership in my hedge fund must be made. For example, BlackRock Vice Chairman Bob Doll's appearances on Bloomberg might disclose BlackRock's significant business/advertising relationship with Bloomberg. And, as another example, Jim Paulsen's frequent appearances on CNBC might disclose that Wells Capital Management is a significant advertiser on the network.

Hedge Fund Managers

"Wild swings in share prices have more to do with the "lemming- like" behavior of institutional investors than with the aggregate returns of the company they own." -- Warren Buffett

The hedge fund community has become the dominant investor over the past two decades. The rewards of differentiated performance, especially in a successful hedge fund, is huge. As a result, the performance pressures are intense. The fear of missing meaningful moves -- especially to the upside -- make for hedge fund catch-up buying (sometimes oblivious to overall macroeconomic strategy or individual company analysis) like we might have seen last week. History shows that hedge fund managers can get even more emotional than retail investors (though there is less emotion, it seems, when markets drop).

We live in an investment backdrop that is tortured by insane volatility.

The disproportionate influence of electronic trading, high-frequency strategies (based on price momentum) and leveraged ETFs (operating in a vacuum of de-risked and inactive individual and institutional investors) corrupt the markets by exacerbating price trends (both up and down). These exaggerated moves tend to obscure any sense of fair market value at any given point in time and too often influence unduly our own investment behavior.

"Obviously the thing to do was to be bullish in a bull market and bearish in a bear market." -- Edwin Lefèvre (Jesse Livermore), Reminiscences of A Stock Market Operator

The game does not change and neither does human nature. So, how should the average investor respond to the manic markets?

First, as I have consistently written that perma-bears and perma-bulls are attention getters, not money makers. When the roars of the perma-bears (within and outside of the media) sound the most loudly (usually after a sharp market downturn) and/or the roars of the perma-bulls sound equally voluminous (usually after a sharp market ramp) and the fundamentals of the market and the state of the world's economies have not changed, consider buying when things look the worst and selling when things appear to be the best in the market. But, in the main, it usually pays to ignore both groups and to typically graze in between both of those extreme strategies. As to the media, listen (to those in the press box) and their guests (playing on the field) but respond only after doing your own analysis.

Second, the investment mosaic is remarkably complex. Given that complexity and the likelihood of numerous economic outcomes, no single statement (e.g., bulls exclaiming that "stocks are good for the long run" or Cassandra roaring that "the sky is falling") should be taken seriously.

Third, even the most bullish investors should consider hedging strategies against a long book, given the tail risks from the last cycle, the structural headwinds and economic challenges, among other issues.

Fourth, even the most bearish investors should consider some long exposure, especially since stocks (regardless of the economic headwinds) are inexpensive relative to interest rates and have had a decade of neglect.

Fifth, consider "professional" money management (based on hard-hitting analysis and a flexible investment strategy) rather than "doing your own thing." Or at least consider a portion of your stock portfolio to be placed in professional hands, in the hands of an organization that understands your risk profile, investment objectives and has a well-defined investment process.

Sixth, if you are trading for yourself, consider a more opportunistic trading approach with your investment portfolio. As I have recently written, let the market's gyrations work in your favor -- at least until the volatility dies down.

Seventh, invest/trade with your head, not over it.

"I can't sleep" answered the nervous one.

"Why not?" asked the friend.

"I am carrying so much cotton that I can't sleep thinking about. It is wearing me out. What can I do?"

"Sell down to the sleeping point," answered the friend.

-- Edwin Lefèvre, Reminiscences of a Stock Market Operator

Always maintain position size that you are comfortable with and sell down to "your sleeping point." Given the rising volatility over the past two years, keep average positions small and trade for singles and invest for doubles -- and err on the side of conservatism.

Eighth, during these periods of stress, take some time off and compile an investment library and begin to read books written by investors and traders who have succeeded on the playing field and have "walked the walk" as opposed to those in the press box or in academia who simply "talk the talk." What follows is a list of investment books I have previously recommended on Real Money Pro. You will likely learn more practical investment strategies and risk-control techniques from these investment wizards than spending a year in a Wharton classroom. (And you will save $65,000 in tuition and board!)

Howard Marks' The Most Important Thing

Jim Cramer's Getting Back to Even, Stay Mad for Life: Get Rich, Stay Rich (Make Your Kids Even Richer), Mad Money: Watch TV, Get Rich, Real Money: Sane Investing in an Insane World, Confessions of a Street Addict, You Got Screwed! Why Wall Street Tanked and How You Can Prosper

Barry Ritholtz's Bailout Nation

Michael Lewis' The Big Short

Andrew Ross Sorkin's Too Big To Fail

Richard Bernstein's Navigate the Noise

Michael Lewitt's The Death of Capital

Gregory Zukerman's The Greatest Trade Ever

Charles Mackay's Extraordinary Popular Delusions and the Madness of Crowds